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Shadow Banking and the Four Pillars of Traditional Financial Intermediation

Emmanuel Farhi, Jean Tirole

NBER Working Paper No. 23930
Issued in October 2017, Revised in February 2020
NBER Program(s):Corporate Finance, Economic Fluctuations and Growth

Traditional banking is built on four pillars: SME lending, insured deposit taking, access to lender of last resort, and prudential supervision. This paper unveils the logic of the quadrilogy by showing that it emerges naturally as an equilibrium outcome in a game between banks and the government. A key insight is that regulation and public insurance services (LOLR, deposit insurance) are complementary. The model also shows how prudential regulation must adjust to the emergence of shadow banking, and rationalizes structural remedies to counter financial contagion: ring-fencing between regulated and shadow banking and the sharing of liquidity in centralized platforms.

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Document Object Identifier (DOI): 10.3386/w23930

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